Professional negligence: An uncivil action

A forthcoming Lords decision in the case of Moore Stephens v Stone & Rolls could well see auditors better protected from spurious claims.

Professional negligence: An uncivil action The case of Moore Stephens v Stone & Rolls (2008) first made headlines as the largest case involving third-party ­litigation funding. However, the recent Court of Appeal judgment of 18 June is a significant decision in its own right and may serve to limit the liability of auditors. The liquidator is reported to have appealed to the House of Lords.

The decision, in favour of the auditor, was the result of a beautifully constructed legal analysis of the ex turpi causa non ­oritur actio – the doctrine that an action may not be founded on illegality – put forward by Jonathan Sumption QC. The fraud involved Stone & Rolls persuading Czech bank Komercni Banka (KB) to pay $90m (£45.34m) to the company based on false letters of credit, and the company then ­forwarding some $80m (£40.3m) to an ­Austrian company, BCL Trading, which was connected with Zvonko Stojevic, the sole directing mind and will of the company. Other banks were also duped.

The frauds gave rise to claims by KB against both the company and Stojevic in deceit, and KB was awarded substantial ­damages against both. The company could not pay and went into liquidation. Stone & Rolls then claimed against its auditor, Moore Stephens, for negligently failing to detect Stojevic’s dishonest behaviour, seeking ­damages of just under $174m (£87.66m).

Moore Stephens applied to have the ­company’s claim struck out. It argued that, where the company perpetrated the fraud, the ex turpi causa defence applied, because under that doctrine the company could not as a matter of public policy be allowed to seek to recover losses incurred by its own fraud.

It was common ground that if the company was the victim of the fraud, the defence did not apply. Sumption argued successfully that the company was villain not victim, as the fraud was carried out by the company against third-party banks. Nor was it a situation whereby the company was being held vicariously liable for its employees’ actions. Rather, as the company was controlled by the ­principal architect of the fraud, Stojevic, it was a case of the company being imputed with knowledge of Stojevic and itself perpetrating and being directly liable for its frauds.

The main battleground turned on whether the ex turpi causa defence could not apply against the auditor because the fraud was the very thing that the auditor had been paid to protect the company against. Sumption persuaded the Court of Appeal that the fraud argument could not apply because that argument went to causation arguments (eg was discovery of the fraud within the scope of the auditor’s duties), not whether the ex turpi causa defence applied and where, as here, ex turpi causa did apply because the company was villain not victim, there was no court discretion, it was a ­complete defence.

We would suggest the following ­summary of the effect of the judgment. An auditor ­cannot be held liable for losses that arise from liabilities incurred by the company towards third parties caused by a company’s fraud, where the fraud is perpetrated by the controlling mind(s) of the company.

To what extent this decision means that losses suffered by companies through fraud practiced by its senior management are no longer all recoverable against auditors will bear careful consideration.

Which brings us onto another very recent development, in the form of Sections 532-538 of the Companies Act 2006, which became effective on 6 April 2008 and which allows auditors to enter into contractual arrangements that reduce or cap their liability for statutory audits – provided such arrangements receive shareholder approval. Prior to this Act auditors in the UK were prohibited from limiting their liability for audit work.

There is no doubt the audit profession has benefited from some sympathetic findings before the UK courts over the past 15 years. The Act states that auditors are now able to limit their liability under English law ­provided the resulting arrangements are “fair and reasonable” in particular circumstances and subject to the approval of the company’s shareholders. Whether this is a good thing will be a subject of continuing debate.

Organisations, including the International Corporate Governance Network, which ­represents significant institutional and ­private investors, corporations and advisers from 40 countries, have criticised some of the suggested forms that a limitation agreement might take – in particular a monetary cap – asking whether it could ever be in a company’s best interests to come to such a limitation agreement with its auditor.

The Moore Stephens case can only help the cause of the auditors. Is it right for ­auditor firms to face claims for huge losses that are wholly disproportionate to the ­professional fees they charge for auditing – particularly when cases can now be funded by third-party funders? The fact that such a case can be shown to lack merit does not remove the sense of disproportionality – on the contrary, it underlines it.

We await the outcome of the appeal to the House of Lords’ decision in Moore Stephens’ case.

Richard Highley is a partner and Graham Ludlam an associate at
Davies Arnold Cooper